What is Capital Account Convertibility?

What is Capital Account Convertibility?

Currency convertibility refers to the freedom to convert the domestic currency into other internationally accepted currencies and vice versa. Current account convertibility means freedom to convert domestic currency into foreign currency and vice versa to execute trade in goods and invisibles. On the other hand, capital account convertibility implies freedom of currency conversion related to capital inflows and outflows.

Compared to current account convertibility, capital account convertibility is a complex issue because of the peculiar feature of capital account transactions. An important one is the high frequency and volume of international capital movements across borders which may produce many macroeconomic effects in host countries like India.

Meaning of Capital Account Convertibility (CAC)

Capital Account Convertibility is not just the currency convertibility freedom, but more than that, it involves the freedom to invest in financial assets of other countries. The Committee on Capital Account Convertibility (1997, Chairman Dr S S Tarapore) in its report has given a working definition for the CAC which is as following. “CAC refers to the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange. It is associated with changes of ownership in foreign/domestic financial assets and liabilities and embodies the creation and liquidation of claims on, or by, the rest of the world.”

Capital account convertibility is thus the freedom of foreign investors to purchase Indian financial assets (shares, bonds etc.) and that of the domestic citizens to purchase foreign financial assets. It provides rights for firms and residents to freely buy into overseas assets such as equity, bonds, property and acquire ownership of overseas firms besides free repatriation of proceeds by foreign investors.

Why capital account convertibility?

Countries prefer capital account convertibility to promote the inflow of foreign capital. Despite the various risk associated with capital flows like fluctuations in various segments of the financial market, countries like India goes for it to get the advantage of having additional foreign capital.